December 28, 2006

The Estonian Model

* The disturbing return of socialism and authoritarianism in the former Soviet bloc

Is Liberalism Dead in Central Europe ?

Given these institutional weaknesses in the post-communist countries, some economists, including the Nobel laureate Joseph Stiglitz, have argued that liberalization should have been slowed down. But the cost of postponing reforms, whether in terms of subsidies to inefficient producers or of forgone economic growth, would have been immense.

Moreover, Oleh Havrylyshyn, the former deputy director in the Office of Internal Audit at the International Monetary Fund, shows in her new book, Divergent Paths in Post-Communist Transformation, that by virtually all the relevant criteria, from growth rates to corruption, Central European nations have performed significantly better than formerly communist countries that took a more gradualist or haphazard approach to reform, such as Russia and Ukraine. Central Europe, in turn, is outperformed by Estonia, the most fervent liberalizer in the post-communist world.

Estonia began to liberalize at the end of 1992. The government eliminated import tariffs and instituted a flat income tax. Corporate taxes on reinvested profits fell to zero. To arrest inflation, the government established a currency board, which tied the exchange rate of the Estonian kroon to the deutschmark and, later, the euro. State enterprises were sold off in a transparent fashion ; unlike in Central Europe, Estonian privatization favored the highest bidders regardless of their political connections. Foreign investors were welcomed, though Russian firms were treated with suspicion due to national security concerns.

Like all the formerly communist countries, Estonia initially entered a recession as inefficient firms folded. By 1995, though, its economy was growing again. According to the World Bank, its per capita GDP grew at a compounded average annual rate of 6.9 percent between 1995 and 2004. Poland, the best-performing Central European country, grew by only 4.5 percent during that period. Adjusted for inflation and purchasing power parity (which accounts for variations in consumer prices across countries), Estonian per capita GDP rose by 96 percent—twice the rate in Hungary, the best-performing Central European country by this measure.

The real problem with Central Europe’s economic transition was not that it went too fast but that it did not go fast enough. The amount of money available to Central European governments some 16 years after the fall of communism continues to astonish. On average, the region spent 44 percent of its GDP on a variety of welfare schemes, subsidies, and government purchases in 2005. By comparison, Estonian government spending was 36 percent of GDP. Slovakia spent as little as Estonia, but the overall level of economic freedom in Estonia was considerably higher, thanks to Slovakia’s heavy regulatory burden. In 2005 Slovakia had the 37th most welcoming business environment in the world, as measured by the World Bank’s Doing Business report, while Estonia came in 16th.

According to Transparency International, Estonia also has the lowest level of corruption in the post-communist world. That supports the argument that corruption in the former Soviet empire is related to the size and scope of government.